Eve of (Self) Destruction

By William Davis

“But you tell me over and over and over again my friend,
Ah, you don’t believe we’re on the eve of destruction.”

Barry McGuire, singer and songwriter

We suspect commodity traders like to use the word “contango” in conversation whenever they can. Can’t blame them really. Not only does the word sound kinda’ cool — kən táng gō — ordinary, non-futures type folks have absolutely no idea what it means. Those with a Series 3, on the other hand, are less impressed. They know the word simply refers to when the futures price of a commodity is above its expected spot price. A normal market, in other words.

“This is the volatility event that we’ve been waiting for. A lot of people have become complacent.”

Commodity traders try to profit on the contango situation in flat markets by shorting (selling) near-term futures on indexes, rolling the positions forward as the contracts expire, and keeping the proceeds Utilizing the strategy, more than a few in the pits have made a ton of money over the last few years shorting one of the flattest and calmest indexes in history — the CBOE Volatility Index, or VIX. The so-called “short-Vol” trade has, in fact, been easily profitable across this bull market. Until Monday, the S&P 500 enjoyed 404 consecutive trading days without a 5% correction, the longest such streak since September 1959.

“Money kept pouring into the ETN, but it’s a dangerous product that most people didn’t understand.”

We shouldn’t be surprised, then, that Wall Street jumped all over the chance to deliver a complex, impossible-to-understand short-Vol product to ordinary, non-futures type folks. With the introduction of the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, symbol XIV, Credit Suisse did indeed make it possible for retail investors to trade volatility alongside the most sophisticated hedge funds in the world. Ignited by a 46% compound annual return from its inception to two weeks ago, assets in the note blew up to $2 billion.

“Two years of huge gains of as much as 800% in these products have turned to catastrophic and even total losses in just two weeks.”

But the product was built to contain the seeds of its own destruction. By prospectus, in the event of very sharp spikes in volatility – the very kind we’ve experienced recently — Credit Suisse reserved the right to liquidate the note to avoid being caught on its own hook. Which it did. As it happened, Monday’s record rise in the VIX index created a feedback loop in the futures market that prompted the bank to hedge itself in after-hours trading to keep the note’s value above zero. That action drove up the index and caused a permanent loss in the note. XIV was doomed to die.

“I watched it sink, sink, sink after hours.”

Credit Suisse says that XIV’s last day of trading will be later this month. A reminder that when it comes to investing, there’s no such thing as an “easy money” trade.

What the pundits have been saying…

“At the worst times to buy in the last 30 years, the stock market has been the best generator of wealth of any asset class.”

“Us little guys working our butts off, we can’t get ahead. This (Bitcoin) is a once-in-a-lifetime opportunity to change my life.”

35-year old Kentucky resident Cedric Knight

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